Hedging Currency Risks at AIFS

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Transcript of Hedging Currency Risks at AIFS

Hedging Currency Risks at AIFSHow does AIFS make money?What gives rise to currency risk at AIFS? What are the risks they face?CASE ANALYSISWhat would happen with 100% hedge with forwards? With futures? Use the forecast final sales volume of 25000 and analyze the possible outcomes relative to the zero impact scenario?What happens if sales volumes are lower or higher than expected as outlined at the end of the case?What would happen if Archer-Lock and Tabaczynski did not hedge? Presentation BreakdownExecutive SummaryCase Questions/AnalysisConclusionBibliographyWorks Cited

http://www.aifs.com/cyril_taylor.aspAIFS uses two different pricing decisions for the College and High School Travel divisionsBoth programs take into account their cost base, competitive pricing and the hedging activities The College division worked from July 1 to June 30, or the academic planning year. June 30 of the previous year was the deadline for setting prices for any given year. Throughout the year Archer-Lock met regularly with marketing and operations managers to discuss sales forecasts and events that might affect sales. The managers also put out weekly sales forecasts, which Archer-Lock could use to base his hedging activities. The ACIS catalog contained about 35,000 prices combining tours, seasons and departure gateways. Set by Tabaczynski on a calendar year basis, January to December. The strategy Tabaczynski wanted ACIS to follow was a slow, but steady price increases year by year. This strategy was implemented to avoid sudden price hikes and even if ACIS was $200 more than their competitors over time their customers didn’t seem to care. ACIS’s customer were very loyal: over 70% of the teachers were returning customers Zachary Connolly, Pai Gao, David Hall, Dana Weinberg, Huan Xu, and Huan ZhangFIN 659-01: Professor Gopala VasudevanExecutive Summary Problem: Should AIFS hedge? What hedging decisions would you advocate?

Solution(s):Conclusion100% Options = Best hedging decision for AIFS"Right vs Obligation" ***QUESTIONS***American Institute for Foreign Studies (AIFS) founded in the U.S. in 1964 by Sir Cyril Taylor (HBS MBA 1961) [Pictured right]Sent more than 50,000 students each year on academic and cultural exchange programs worldwideCurrency mismatches: Revenues in USD ($200 million annually)Costs in other currencies (EUR and GBP)Two main divisions:Study Abroad College divisionHigh School Travel division: Founded in 1978 as the American Council for International Studies (ACIS)Other divisions:Au Pair divisionCamp America divisionAcademic Year in America (AYA)Pricing:"Catalog-based" businessNo "price surprises" What is the “nightmare scenario” for AIFS?There are three types of risks:Bottom-line risk: an adverse change in exchange rates could increase the cost base. Volume risk: Foreign currency was bought based on projected sales volumes, which would differ from final sales volumes.Competitive pricing risk: The AIFS price guarantee meant it could not transfer rate changes into price increases.The competitive risk is closely link to the other risks, especially the bottom-line risk.Beyond those three risks: AIFS also faced the risk of the “low margin/high volume” operations of the ACIS division The ACIS division’s sales margins were highly susceptible to world events, such as the 1986 terrorism acts, the 1991 Gulf War, the 2001 September 11 attacks and the 2003 Iraq war. Sales would drop as high as 60% for the ACIS division based on this news. If the dollar is strong (1.01 USD/EUR) then there is a total cost savings of $5.25 million equating to $210 per participant. If the dollar is weak (1.48 USD/EUR), however, there is a total cost negative windfall of $6.5 million equating to $260 per participant. If AIFS chooses a no hedge strategy they face strong bottom-line risk. Forwards vs. Options1yr Forward Rate= $1.2258/EuroOption Premium= 5% at $1.22/Euro Strike25,000 students at a cost of 1000 Euros eachCost of 100% Forward Contract= 25,000*1000*1.2258= $30,645,000Cost of 100% Option Premium= 25,000*1000*1.22*.05= $1525000100% Forward ScenariosStrong Dollar @1.01 in One Year…No Hedge Cost= $25,250,000100% Hedge Cost= $30,645,000Windfall= $30,645,000-$25,250,000 =Loss of $5,395,000

Pay up to only 17.79% more in costs.Sales volume: 30,000Strong USD: 1.48 EUR/USD

Save up to only 14.31% in costs.Low and High Volume with OptionsAIFS is stuck paying the Premium of $1,525,000.The Dollar amount gained and lost is the same as the expected volume…Windfall percent is accentuated for low sales and minimized for high sales.Contracts & OptionsDid Not HedgeProfit1.22 EUR/USDCall Option LossForward ContractsCall OptionsOption PremiumOption PremiumFutures Loss1.01 EUR/USD1.48 EUR/USDMix of Options and Forwards